Tax-free bonds are flopping: Rich say 'no' to cheap money

Every time Finance Minister P Chidambaram finds himself cursing the Reserve Bank of India (RBI) Governor for not cutting interest rates, he should ask himself whether the latter is more sinned against than sinning.

Despite some signs of an easing in inflation rates in November, the market for money is actually sending this message: that rates cannot, or should not, fall too soon.

Short-term liquidity is very tight. Thanks to advance tax payments, the RBI is lending overnight funds to banks. Reuters

Consider three recent signals.

#1: On the assumption that we are now clearly into a declining rate scenario, many government-owned companies lowered the coupon rates offered on tax-free bonds. But these bonds are not exactly flying off the shelves. This means investors want higher rates.

#2: Even though the big banks are holding deposit rates, smaller banks are feeling the strain. Today's newspapers tell us that both Dena Bank and Federal Bank have raised deposit rates, since money is tight. While Dena has raised rates for deposits between one and two years from 8.75 percent to 9.1 percent from 22 December, Federal has raised it to 9 percent for tenures of one to three years.

#3: Short-term liquidity is very tight. Thanks to advance tax payments, the RBI is lending overnight funds to banks to the tune of Rs 1,63,000-and-odd crore daily. Even though this tightness may be temporary, the figure is still huge given that there is a Rs 1,00,000 crore gap between what the RBI considers a healthy liquidity gap and what it is now. Also, the advance taxes sucked out just Rs 78,000 crore from the system - which means liquidity is tightening for other reasons, too.

Of the three signals, the inability of issuers of tax-free bonds to mop up resources is telling. At coupon rates of 7.69 percent for 10-year bonds and 7.86 percent for 15 years, the pre-tax yields for people in the top brackets are as high as 11.13 percent and 11.37 percent-well above even consumer price inflation.

But, as Business Standard reports, investors, even high-net-worth investors, are not taking the bait of higher pre-tax yields.

The report says that Power Finance Corporation's Rs 5,600-crore bond issue (including the green-shoe option) has been extended by nearly a week to close on 27 December since it had obtained only 60 percent bids. Rural Electrification Corporation raised only Rs 3,000 crore against a target of Rs 5,500 crore, and bankers are keeping their fingers crossed on the India Infrastructure Finance Company's bumper offer of close to Rs 10,000 crore which opens on 26 December offering similar interest rates.

The newspaper quotes wealth manager Raghvendra Nath of Ladderup Wealth Management as saying: "A yield of 7.2 percent is not exciting for HNIs (high net worth investors) or companies, despite being tax-free, because the returns are much lower than the 8.1-8.3 per cent they received last year."

*There is only one reason why this must be so. Inflationary expectations are still high, both among consumers and investors.

Moreover, with the stock market showing signs of a revival, HNIs, who get about 0.5 percent less than retail investors in tax-free bonds, have other options.

Clearly, the finance ministry's efforts to talk up the markets while trying to push interest rates down is sending contradictory messages in a business scenario where demand for funds is rising, inflation expectations are still high, and foreign flows (being encouraged to keep the rupee down), are raising stock prices.

Investors and savers are telling us that interest rates need to remain high for a while longer.

Governor Duvvuri Subbarao is not alone in wanting to keep rates high, Mr Chidambaram. The market is sending the same message.